It is well known that India has very little by way of social security. The Employees’ Provident Fund (EPF) serves a minority of the population, and even that does not provide a big enough retirement nest egg. Which is why the news about a universal voluntary pension scheme generated so much interest when it was first mooted. The New Pension Scheme (NPS) will be launched on 1 April this year by the Pension Fund Regulatory and Development Authority (PFRDA) and will be open to all citizens.
Consider the statistics the number of people above 60 years of age is expected to grow from 88 million in 2005 to 100 million in 2010, and to 330 million by 2050. Estimates are that an Indian reaching the age of 60 today can expect to live for 20 years, with women outliving men by three-four years. The life expectancy will only increase in the future. So each person will require support for a longer period, needing more resources. There are no two thoughts on the need for a voluntary pension scheme. Considering the limited choice in long-term pensions, this could be one scheme that can change the retirement landscape.
On the face of it, there seems little reason for you not to join this scheme; after all, there’s no such thing as too much security. This is a government-backed offering, so it’s bound to be safe. Enter, but do so with your eyes open. This is a new scheme with issues that are not fully resolved, and some matters that could be of concern. We take a look at the features of the scheme as we know it and examine the options open to those of us who want to ensure that our retirement does not bring along a host of financial worries.
What the new scheme is
Although it has not been specifically described as one, the NPS is a defined contribution scheme, which will allow members to make contributions to their individual retirement accounts (IRAs). This amount is invested during the accumulation phase, providing members the best opportunity to benefit from the power of compound interest and the fund options that are available. The members who are not sure of their risk appetite, or those who cannot decide upon a fund option, can stick with the default option, which works on the life-stage principle of higher proportion in equities in the early years, tapering down as the member gets older. The fund options will be reviewed every three years and new options may be introduced over time.
After retirement, which is the payout phase, a certain proportion can be withdrawn as a lump sum and the balance must be compulsorily invested in annuities that give a domesregular income to the individual. This regular income received by the individual is the pension.
| Wide Choices The NPS will offer investors a wide variety of funds to choose from. One can opt for the fund that suits his risk and age profile. |
| NPS Fact file Minimum investment: Rs 6,000 Modes of payment: Quarterly, half-yearly and annual. Investment options: Equities, corporate bonds and govt bonds. Investors can choose the mix. Default option or auto choice: Up to 35 years, equity exposure will be 65%; thereafter every year this will fall by 10% till the investor reaches 60 years. Charges: Registration charge of Rs 40; transaction fee of Rs 20; switch charge of Rs 10; annual CRA fee of Rs 350. Fund management fee: 0.09 basis or 0.0009%. Fund managers: PSUs: UTI Retirement Solutions, SBI Pension Funds and IDFC Asset Management. Private: Reliance Capital Asset Mgmt, ICICI Prudential Life Insurance and Kotak Asset Mgmt. PFRDA will provide a three-year licence to the pension fund managers and it is for the NPS contributor to choose the fund manager |
| Compulsory pension schemes If they are offered by the employer, workers have to join these schemes | ||
| Scheme | Eligibility | Financing |
| Employees Provident (EPF) | Employees in firms with more than 20 staffers | Contributions by employee and employer |
| Employees Pension (EPS | Same as above with a few exemptions and exclusions | Contributions by employer and government |
| Civil Services Pension | Civil servants and state and federal level | State or central government budgets |
| Government PF* | Civil servants and state and federal level | Employee contributions |
| Central Govt Pension Scheme** | Civil servants and state and federal level | Employee contributions |
| Special Provident Fund | Certain occupations (secret services) and employees in J&K | Contributions by employee and employer |
| * Applicable to those who joined services before 1 Jan 2004; **Applicable to all central govt services from 1 Jan 2004 | ||
| Voluntary and tax-deferred pension schemes An individual can voluntarily invest in these pension schemes | ||
| Scheme | Eligibility | Financing |
| Public Provident Fund (PPF) | All individuals | Self-contribution |
| Superannuation plans | All employees | Self-contribution |
| Personal pension plans | All individuals | Self-contribution |
| State-level social assistance | Depends on state policy | State budgets |
| Sr Citizens Savings Scheme | Above 60 years | Self-contribution |
| National old age pension | Destitutes above 65 years | Central budget |
| - Lump-sum income received from PF and PPF is tax-free. - Pension income is taxable, but up to 33% of the pension corpus can be commuted on maturity. The rest has to be invested to earn pension. - Capital appreciation in personal pension plans is taxed only at withdrawal. |
The positives
The over-riding benefit of the NPS is the flexibility that it offers to members, both in terms of plan options and fund managers. It is also a portable scheme, which allows members to access their accounts from anywhere in the country. Although the exit age is 60, early withdrawals will be allowed. Says Dhirendra Swarup, chairman, PFRDA: “The objective is to encourage people to save for retirement over the long term. But there are a few exceptions where we will allow early withdrawals. For instance, for a terminal medical emergency or for purchasing a house for living we will consider an early withdrawal from the scheme.”
Critics of the NPS say that launching a pension scheme when the world is facing a recession is not a wise move. However, the global economic crisis seems to have sharpened the already existing need for social security. The government, on its part, seems confident that the scheme will find enough takers. Says U.K. Sinha, chairman and managing director, UTI Asset Management Company: “Though the PFRDA Bill is yet to be passed, the government has cleared the scheme. This indicates how much confidence it has in the scheme and its benefits.” In fact, a survey by IIMS Dataworks estimates that there would be about 80 million subscribers to this scheme in the first five years.
Apart from the benefits to members, the NPS will generate a significant pool of long-term savings, which will be available for investment in the financial and capital markets. India’s need for investment in infrastructure is well known, as is the volatility in the capital market due to a relatively low share of investments of domestic provident, pension and other institutions. The pool of savings accumulated by this scheme, and invested prudently, can help in striking a better balance between domestic and foreign investors.
The country has a high domesrtic savings rate and if that can be channelised into this scheme, it can only strengthen the capital markets. India’s growth fundamentals and growth strategy are expected to grow 5-6% in 2009, when the global economic growth is likely to be flat. Sustaining this upswing will require higher domestic savings. While the NPS is expected to increase net household savings, it is essential that public sector and business sector savings are also increased to provide resources for investment. And it can work well if companies also route their employees’ long-term pension benefits to this scheme.
The negatives
This is a new scheme and there are bound to be problems and critics. The biggest drawback is the lack of a tax incentive. Currently, savings instruments are taxed on an EET basis (exempt, exempt, tax). The NPS will fall in this category, and so contributions and accumulation will be tax-exempt, but withdrawal of any amount on maturity will be taxed. “There is a huge tax disincentive that will make this scheme unattractive despite the low cost of fund management,” says Manik Nangia, Corporate Vice-President, product management, Max New York Life Insurance. The EPF, government PF and the public PF, however, are in the EEE bracket— which means all three phases of investment, accumulation and withdrawal are tax-exempt.
There are also few incentives for agents to sell the scheme, unlike in mutual fund and insurance distribution, where commissions are earned on customer acquisition. Nangia says, “For retirement plans, we work on a ceiling of 7.5% commission in the first year, and despite this we find it tough to find takers for retirement plans.” The PFRDA hopes that members will flock to the NPS without any impetus from the distributors. Considering that most other financial plans are sold and not bought, this seems unlikely.
As the scheme is voluntary, there is no penalty for not contributing. This is not a disadvantage on the face of it, but calls for intense discipline to continue investing. Also, to make the scheme work well, a member will need to track and closely observe the performance of his fund and be actively involved with it.
Finally, and most important, as Sinha says, “The scheme will be effective only when the PFRDA Bill is passed in Parliament. Until then, the PFRDA has no legal teeth in case of any dispute.”
| Analysing the features of the NPS Though the NPS has several positive features, it is not without its share of drawbacks. Here are some of the favourable aspects of the scheme and some areas where it does not score. | |
| Pros | Cons |
| Simple: Scheme is easy to comprehend. Scalable: It can add many new numbers. Portable: It can be accessed from anywhere in the country. Flexible: It offers flexible payment and investment options. Low costs and charges:It is the cheapest managed fund. | Not mandatory: It is not compulsory to join the scheme. Low awareness: Low financial literacy means no economies of scale. Low tax incentives: Pension is taxable at normal rates. Nascent stage: Distribution network to be set up by the players. |
What it costs
Because it is targeted at organised and unorganised sector employees, the NPS does not have insurmountable cost barriers. You will have to pay Rs 350 as a joining fee and Rs 40 as a registration fee. Once your account is created, you will receive a Permanent Retirement Account Number or PRAN. The only incremental cost is a Rs 20 transaction charge that has to be paid each time a fresh contribution is made to the account.
Apart from this, you pay a fund management fee. Based on competitive bidding, this works out to a ludicrously low 0.0009%, making it by far the cheapest actively managed fund in the country. The 0.0009% fee means that the fund manager will charge Rs 9 as fund management fee for taking care of Rs 10 lakh. In contrast, the same investment in an equity scheme of a mutual fund would cost you Rs 22,500 upfront (entry charge), while a debt scheme will charge about Rs 6,000. Additionally, a mutual fund will charge up to 1.75% on your total corpus every year as fund management charges.
On the flip side, the low cost will work only if the numbers are sufficient. And that is the biggest challenge that the scheme faces. Swarup is hopeful that the PFRDA’s literacy drive will bring in the numbers, but this is likely to be an uphill task. There is also the issue of a compulsory annual contribution, which is yet to be fixed. If this amount is too high, the scheme might have to cope with high delinquency rates.
| The world of pension The US has the largest share of the world’s pension fund assets. It accounts for over 40% of the world’s total pension fund corpus. | ||||
| Country | 2004 | 2005 | 2006 | 2007 |
| Australia | 4,43,443 | 5,48,928 | 6,58,867 | 9,20,668 |
| United Kingdom | 14,67,118 | 17,63,762 | 20,02,059 | NA |
| United States | 86,04,685 | 91,71,518 | 99,45,118 | 1,02,38,127 |
| France | 24,845 | 24,845 | 25,094 | 27,397 |
| Germany | 1,04,143 | 1,12,534 | 1,22,764 | 1,36,456 |
| Japan | 3,73,380 | 3,01,994 | NA | NA |
| Korea | 11,516 | 14,652 | 26,624 | 29,786 |
| All figures in million US dollars Source: OECP Pension Statistics | ||||
| - The total assets of the world’s 300 largest pension funds were over $10 trillion in 2007. - Pension funds are a long-term investment and play a crucial role in the stock markets and infrastructure development of a nation. - The Indian pension market is just opening. The total pension fund corpus is pegged at Rs 3,00,000 crore. - Pension funds are high on the govt and corporate agenda across the world |
The bottom line
For the scheme to be successful, fund management will have to be transparent. It’s also likely that when the PFRDA Bill is passed, there will be need for amendments that will bring in clarity on tax treatment as well as on investment regulations. As Swarup says, “This scheme will be the longest term savings or investment instrument in the country and deserves the most preferable tax treatment.”
| - Increasing longevity is a threat to retirement planning. During the accumulation phase, the individual may not have planned his retirement savings to support him for so many years. - The number of workers supporting each retiree is decreasing by the year. The fewer supporting workers there are, the more each must pay because of the increasing longevity. - Since birth rates are coming down, older people have fewer working people on whom they can depend financially. - Rising dependency ratio, a combination of ageing population and shrinking number of supporting workers will take its toll as longevity rises. |
Also, considering that the existing retirement plans offered by insurance companies are regulated by Irda (Insurance Regulatory and Development Authority) and those by mutual funds by the Securities and Exchange Board of India (Sebi), PFRDA will have to bring in its own set of regulations or adopt either or both the existing regulations.
There are challenges in developing annuity markets the world over, particularly as longevity trends are uncertain. Matching assets and liabilities for annuities by insurance companies is a challenge. So, PFRDA might have to consider phased withdrawals, with some risk-pooling for at least a minimum amount. Further, when consulting regulators, the RBI must make sure to consult PFRDA as well, to ensure that regulatory changes are not overlooked.
Based on international experiences in the US, Australia, Singapore and elsewhere, the key requirements for successful voluntary NPS are as follows.
First, the design of NPS should take into account the lessons arising from behavioural finance, especially the role of inertia in choosing investment composition. Says Kapil Mehta, managing director & CEO, DLF Pramerica Life Insurance Company Ltd: “The biggest myth that financial companies carry is that customers know what is best for them.” They obviously don’t, especially when you consider the fact that in the US, an overwhelming number of 401K retirement plan holders continue to be overweight in equities even in the current jittery economic environment.
There is also the issue of the life-time poor, who may not be part of this scheme or have sufficient retirement savings. In this context, social pensions, such as the Old Age Pension scheme, jointly financed by the states and the Centre, must be strengthened. Some experts reckon that the minimum annuity should match at least the minimum wages that the government stipulates, all of which will require fiscal reforms, and more effective government service delivery systems.
Yes, it is high time the government went ahead with the NPS, but as a prospective member, you need to proceed with caution. Remember that this might be a good scheme, but it should make up only one of the elements in your retirement plan, and, on a macro level, in the country’s total pension schemes.
| Where to buy As many as 23 entities have been approved by PFRDA for appointment as Points of Presence (POPs) for the New Pension Scheme. All citizens other than government employees covered under the pension scheme can buy into the NPS through these entities. | |
| 1. Allahabad Bank 2. Axis Bank Ltd. 3. Bajaj Allianz General Insurance Co Ltd. 4. Central Bank of India 5. Citibank N.A. 6. Computer Age Management Services Private Ltd. 7. ICICI Bank Ltd 8. IDBI Bank Ltd 9. IL&FS Securities Services Ltd. 10. Kotak Mahindra Bank Ltd. 11. LIC of India | 12. Oriental Bank of Commerce |
- Mukul Asher is Professor of Public Policy, National University of Singapore
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